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Haven't we seen this movie before? Seemingly out of nowhere comes a crisis in a small, faraway country known more as a tourist destination than as a financial center. Foreign capital is attracted to this exotic locale, where it finds it is treated well in terms of returns, taxation, and currency risk. But the ensuing bubble inevitably bursts, leading to a panicky rush to the exits. Still, the small size and obscurity of the locale leads the rest of the world to be dismissive of the crisis. That is, until contagion spreads the troubles across borders to bigger centers and begins to affect larger players.

It will be 16 years in July since the run on the Thai baht became the opening act in what would become the Asian financial crisis. Money had flooded into the region, attracted by high returns and the pegging of local currencies to the dollar, which supposedly limited exchange-rate risk. But those pegs broke when foreign investors headed for the exits. The Asian crisis eventually spread beyond the region. Russia defaulted the following year, helping to precipitate the collapse in September 1998 of Long-Term Capital Management, a multibillion-dollar hedge fund.

In 2008, Iceland was the improbable site of a credit bubble and bust. Money flooded into the island nation's burgeoning banks in pursuit of high returns. Eventually, the amount at issue grew to about 10 times the size of Iceland's economy. But the bubble's collapse led to defaults to foreign creditors, notably those in the U.K. and the Netherlands, and a massive devaluation of Iceland's currency, the krona.

It's also been about three years since the euro-zone crisis began with the unraveling of Greek government bonds, which previously had been quite far off virtually all investors' radar screens. Investors, such as big European banks, were attracted to these bonds because, being denominated in euros, they should be no riskier than benchmark German government paper. That is, so long as the bonds could be paid back. You know the rest; private holders of Greek bonds took a haircut as part of the bailouts, while banks in Ireland, Spain, and Portugal required bailouts, too.

Now, the crisis has flared anew in the euro zone's easternmost outpost in the Mediterranean, Cyprus. On Saturday, March 16, the first day of a three-day holiday weekend on the island nation, Cyprus announced plans to levy a 6.75% tax on bank deposits of 100,000 euros (about $130,000) or less, and a 9.9% tax on deposits over that mark.

The announcement stunned not only the bank's customers but the global financial markets because it violated a crucial principle going back to the 1930s: that bank deposits would be protected. But instead of protecting depositors, as the Federal Deposit Insurance Corp. does for Americans, the Cypriot government would be taking a portion of bank customers' money. That would produce some €5.8 billion that Cyprus needed to raise in order to receive €10 billion from the "troika" of the International Monetary Fund, the European Central Bank, and the European Union. Cyprus' parliament promptly voted down the proposed levy.

Why should anybody care about Cyprus, which accounts for a mere 0.2% of the euro zone's economy? As in virtually all of these crises, the financial sector dwarfs the real economy. According to BCA Research, assets of Cypriot banks equal 7.1 times Cyprus' gross domestic product, a result of the island's becoming an offshore banking center that especially caters to rich Russians. That is exceeded only by Luxembourg, whose banks' assets equal 21.5 times its GDP, and Malta, with bank assets totaling 7.9 times GDP. Even major international financial centers, such as the U.K. and Switzerland, have bank assets of 5.1 and 4.8 times GDP, respectively. In the U.S., bank assets total 0.8 times GDP.

The reality is that Cyprus became a mini-European version of the Cayman Islands, a salubrious venue for the wealthy for second homes and stashed wealth. That boosted the country's economy, with a large portion of the workforce employed by the financial sector, and worked against the rest of Europe's willingness to rescue it. German reluctance to help Cypriot banks and their Russian oligarch depositors was palpable, especially with Chancellor Angela Merkel seeking re-election in September. The German electorate already thinks it has kicked in too much to bail out feckless euro-zone debtors.

By late Friday, Cyprus and EU officials were negotiating a deal to come up with the €5.8 billion demanded by the troika as a condition for its €10 billion bailout before a Monday deadline set by the ECB to cut off its lifeline of emergency liquidity assistance and to allow Cyprus banks to reopen Tuesday, after having been shuttered all last week. According to various reports, the Cypriot parliament was considering a plan that would involve some sort of deposit levy, with The Wall Street Journal's Website reporting a possible one-off charge on €100,000-plus accounts. In addition, the Cyprus Popular Bank (also known by its Greek name, Laiki) could be split into a "good bank," which would have the under-€100,000 deposits, and a "bad bank" with larger deposits, including foreigners' accounts. None of this had been finalized, but the parliament late Friday did approve capital controls to prevent a run on the banks. As was true in earlier segments of the euro-zone crisis, officials were likely to meet throughout the weekend and would probably be thrashing out a workout right until the ECB's Monday deadline.

THAT STILL DOESN'T ANSWER why anybody should care about what happens in Cyprus, which is a tiny speck on the map, closer to Lebanon and Syria than to London or Zurich. Indeed, writes Christopher Wood in CLSA's Greed & Fear letter, "It is natural that investors should want to look through Cyprus as being a 'special' case and therefore not relevant, just as talking heads initially dismissed Greece's problem because Greece represented only a minimal percentage of European GDP at the beginning of the euro-zone crisis."

But, of course, Greece's liabilities made up a non-insignificant portion of the assets of big financial institutions in Europe, as well as elsewhere. Similarly, the implications of what happens in Cyprus extend beyond that island.

"The euro group's adoption of a strategy with the potential to destroy people's trust in the banking system is a dangerous move, in my view," warns Richard Koo, chief economist at the Nomura Research Institute and a leading expert on the effects of credit bubbles and busts, especially Japan's. If concerns about a deposit tax were "to spread from Cyprus to countries such as Spain and Ireland, where falling real-estate prices have left the financial system in tatters, the euro zone could face a new and far more dangerous phase of the financial crisis," he adds.

As a result, write JPMorgan economists in the bank's Flows & Liquidity research note, capital controls and capital freezes are all but certain in Cyprus, even if a deal gets done to allow the banks to reopen. They note that Iceland still has capital controls, some five years after its banking crisis. A prolonged freeze of accounts would be unacceptable to large depositors, even though they could accept a modest deposit levy, the economists contend.

Large deposits over €100,000 likely account for close to half of the total deposits of the euro zone, the JPMorgan note continues. And with their banking systems representing a large multiple of their economies, "Malta and Luxemburg are equally or perhaps more extreme in terms of their share of less-sticky nondomestic and corporate deposits." At the same time, creditor nations—especially the Netherlands, where economic conditions are deteriorating rapidly—are beginning to feel "bailout fatigue." As a result, there is a shift to "bailing in private creditors in future sovereign bailouts or bank resolutions to avoid using taxpayers' money," they add.

Indeed, it's impossible for the euro-zone governments to back all of the region's bank deposits, BCA Research points out. The euro area has €8 trillion in deposits, while governments have €4.5 trillion in annual revenue. In Cyprus, banks have virtually no bond debt, as they are flush with foreign deposits. In Spain and Ireland, bank bondholders took the hit.

The latest flareup in the euro-zone crisis could add to signs of weakening in Europe's economies. German business confidence unexpectedly dipped in March, according the IFO Institute in Munich. The latest "flash" purchasing managers' survey from Markit gives "the clear message" that the current quarter will be the sixth consecutive one of falling euro-zone GDP, writes James Ashley, RBC Capital Markets' senior European economist.

That's also the message of the markets. John Mendelson, the veteran technical guru at International Strategy & Investment Group, points to a technical breakdown in copper, which he says peaked just over two years ago. He recalls Dr. Copper—the commodity said to have a Ph.D. in economics because of its forecasting ability—topped out in May 2006, some 17 months before the stock-market peak of October 2007. In addition, the Dow Jones Transportation Average took a 1.5% hit last week, paced by a sharp drop in
FedEx FDX 0.08758101243650376%FedEx Corp.U.S.: NYSEUSD171.42
0.150.08758101243650376%
/Date(1438376830715-0500)/
Volume (Delayed 15m)
:
1117103AFTER HOURSUSD171.21
-0.21-0.12250612530626531%
Volume (Delayed 15m)
:
82567
P/E Ratio
47.567777561950216Market Cap
48414148827.3377
Dividend Yield
0.5833625014584063% Rev. per Employee
416254More quote details and news »FDXinYour ValueYour ChangeShort position
(ticker: FDX), hardly a harbinger of strength. Meanwhile, the Dow wound up barely in the red for the week.

Whether concerns about Europe or elsewhere are hitting the global economy should emerge once earnings season gets under way next month. Guidance from managements about prospects for future quarters should give a clearer picture of whether the euro jitters, plus U.S. fiscal tightening, are having a real impact.